Fears of Capital Controls Rise as Indian Rupee Falls

Concerns are rising that India might implement broad capital controls to stem the plunge in its currency and shares.

Those fears were inflamed last week after the central bank reduced the amount of money Indian residents and companies can send abroad, and limited the potential uses for that money.

The measures spooked foreign investors, who fear they presage broader restrictions to prevent overseas investors from taking money out of the economy. That exacerbated a selloff in Indian financial markets, where investors already had been brooding over growing troubles in the economy as growth slows but inflation remains sky-high.

Senior officials including Prime Minister Manmohan Singh have sought to reassure investors and contain the damage. If the currency continues to depreciate, however, the government may be left with few alternatives to broader controls.

The rupee hit a fresh all-time low for the fifth consecutive day Thursday and last was trading close to its record-low of 65.12 to the U.S. dollar. That comes several days after the Bombay Stock Exchange’s benchmark S&P BSE Sensex Index recorded its biggest single-day fall last week and bond yields rise to multi-year highs as investors cash out.

In contrast, Thailand’s 2006 experiment with capital controls was quickly reversed after it sparked a 15% drop in the country’s stock market in a single day. Earlier this year the government gave the Bank of Thailand authority to use capital controls after sustained inflows pushed the baht to multi-year highs, but they ultimately weren’t needed as markets began to anticipate a tapering of the U.S. Federal Reserve’s bond-buying policy, sparking an outflow of cash from Asia’s emerging markets.

International regulators traditionally have opposed restrictions on capital flows, but opposition has softened since the global financial crisis in 2008. In a document last December, the International Monetary Fund argued that rapid outflows can deplete FX reserves and cause currencies to collapse, stress countries’ financial systems and diminish economic output.

Still, the IMF warned that capital controls shouldn’t become a substitute for measures to address deeper structural problems. Instead they should be part of a wider policy package that includes macroeconomic, financial sector, and structural measures, the fund said.

Economists see the RBI’s recent moves as temporary steps to halt the rupee’s slide. But they say authorities will have to be careful not to signal to foreign investors that their money is locked up in India.

“It will be critical to tread very carefully when it comes to capital controls, manage expectations, and also not use it as a substitute for more appropriate and effective measures,” said Leif Eskesen, chief economist for India and Asean at HSBC.

Scaring off investors would be particularly harmful at a time when India urgently needs foreign capital to finance its gaping current account deficit–a reflection that the country’s imports far exceed its exports.

Earlier this month India announced measures that it hopes will fetch about $11 billion in overseas capital, including asking some state-run firms to issue overseas bonds with implicit government backing. It also will increase oil imports from Iran that it can pay for in rupees under a quasi-barter arrangement. Recently, the RBI also has allowed banks to offer higher interest rates on foreign currency deposits.

The current account gap has helped knock down the rupee 15% this year. A weaker currency drives up India’s import bill, stoking inflation; that in turn limits the RBI’s room to lower interest rates, delaying an economic recovery.

The rupee’s fall also could prompt aggressive market intervention by the central bank, draining the country’s foreign exchange reserves – now about $280 billion, enough to meet import obligations for some seven months — and reviving memories of 1991’s balance-of-payments crisis, when the Indian government nearly defaulted on its overseas debt and was rescued by the International Monetary Fund after pledging its gold holdings as collateral.

D.K. Joshi, chief economist at Crisil, the Indian arm of Standard & Poor’s, said the government will have to address core issues such as fast-tracking industrial projects sidelined by delays in obtaining government approval and creating a more favorable policy environment to attract investors.

He said several pending reforms that have been held up due to lack of political consensus – such as the introduction of a Goods and Services Tax – must be pushed forward.

The RBI’s recent steps “are all patchy measures and are unlikely to provide any sustainable solution to improve the economy,” Mr. Joshi said.

CORRECTION: An earlier version of this story said the rupee fell 16% in 2012. That reference was incorrect and has been removed.

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